Do Friday's European Downgrades Matter?

The chatter on Friday's downgrades of European sovereign ratings debt is all over the place -- from those dismissing it as old news (especially given that S&P warned back on December 5th) to those viewing it as part of a larger and consequential transformation of the international monetary system.

What follows is an attempt to provide a guide to the multifaceted implications.

It focuses on three types of consequences: (i) those that are unambiguous and already reflected, albeit not fully, in market valuations; (ii) those that are less well understood but will become clearer in the next few weeks; and (iii) those that are consequential but where the analytics are still largely unknown at present.

The sovereign debt of European sovereigns was already trading at yields consistent not only with what S&P announced today, but also with more draconian downgrades -- thus the view that the impact on overall yields and spreads would be contained.

Yet there are some differences between signaling an action and actually taking it. First you remove residual uncertainty about the action, including timing and scale. Second, you encourage others to follow. Third, you impact the pattern of investment flows, especially those subject to guidelines and restrictions defined in terms of ratings.

All three are relevant for Europe. The net result has both a quantity and price angle: a decline in future investment flows into the Eurozone, and incremental market pressure that, other things being equal, would be more persistent than would have otherwise been the case.

This speaks to a weaker Euro and recurrent volatility in sovereign spreads.

In introducing a rating wedge at the very inner core of the Eurozone, the downgrade of France in particular impacts Pan-European vehicles. This includes the EFSF which the European Union uses to bailout countries and, in future, banks.

While there is some short-term uncertainty, the scope of these vehicles -- and, therefore, their effectiveness in countering the region's debt crisis -- will be undermined. It also has implications for the ECBs continued willingness to contaminate its own balance sheet.

That takes us to known unknowns, and they are consequential.

It is unclear the extent to which the downgrades will alter the function of the international monetary system over time. It is also unclear how material the incremental headwinds blowing out of Europe will be for countries already facing internal fragilities.

It is unclear the extent to which the downgrades will materially impact the asset quality and capital adequacy of banks and other financial institutions. And there is little clarity on the range of reactions on the part of companies, depositors and households.

Over the next weeks, months and years, we will learn a lot more about the consequences of today's historical downgrades in Europe. What is clear at this stage is that the balance of risks is to the downside, for Europe and for the global economy.